If you’re looking for a tax break this year, there’s still time to open a Solo 401(K). But do your research and seek experts to help you understand the plan, how to manage your account without the need for a custodian which amounts to extra fees, and how to transfer your existing new plan. You’ll find the options for investing and maximizing your contributions are plentiful but the clock’s ticking—you only have until December 31st to open one for 2009.

For the self employed, a fantastic development has occurred over the past few years – the Solo 401(k). One distinct advantage of the Solo 401(k) over an IRA is that it is not subject to paying UBIT on profits from financed real estate. Eliminating UBIT by using a Solo 401(k) eliminates the need to file a return (Form 990-T) as well as the accompanying tax. Sound pretty good so far?

The difficulty in recent times has been obtaining nonrecourse financing. The leader of NR financing in the Self Directed IRA industry for the past few years has been North American Savings Bank. Last year, they took the familiarity of IRA lending and applied it to Solo 401(k). Unfortunately for many Solo(k) investors, this has only been available to plans who choose to name a custodian as trustee of the plan. Qualified plans (which is what all 401k plans are) are different than IRAs in that they are not required by law to name a custodian (bank or trust company) as trustee of the plan assets. Investors who establish Self Directed Solo 401(k) plans that name themselves as trustee for simplicity have not been able to readily obtain mortgage loans for their Solo (k) plan from NASB.

Well, as of this month, NASB has expanded their loan products to include a nonrecourse loan program for self trusteed Solo 401(k) plans. I caught up with Matt Allen to discuss the great news on UNLIMITED RETIREMENT ACCOUNT® Radio. The skinny is that the program is almost identical to the IRA lending program. If you aren’t familiar with their guidelines, check out the URA Radio show podcast as it become available soon.

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Conventional Tax Strategies for Real Estate

Many real estate investors boast of their tax strategy as involving one or more of the following:

Depreciation – This is a tax concept where the property owner pretends that his property is decreasing in value. For residential real estate, it assumes that the property’s improvements will become worthless over 27.5 years. In commercial real estate, the calculation is for 39 years. During each year of property ownership, the owner can take that year’s pro rata depreciation as if it is a loss against the income of the property… which reduces the taxable income of the property, thus reducing the amount of taxes due. Upon future sale of the property, depreciation normally must be “recaptured” which means that there is no more pretending, and the taxes on the truly realized gains must be paid anyways.

Cash out Refi – This is where the owner of the property will refinance the mortgage. The new loan will have a higher balance than the old one, resulting in “cash out”. Because this is just borrowing, it is not a taxable event. Upon future sale of the property, however, taxes will normally be due on the actual gains anyways.

1031 Exchange – Upon the sale of real property, the gains can be deferred if they are used to purchase property of “like kind” within a certain time period. It goes something like this:

• Sell Property A
• Have a “qualified intermediary” receive the proceeds of the sale
• Replacement property (“Property B“) must be identified in writing within 45 days of the sale of Property A
• Property B must be purchased (closed) within 180 days of the sale of Property A

• Property B must be of equal or greater value to Property A
• Both properties must be “like kind”. For instance if Property A was U.S. real estate, Property B must also be U.S. real estate.

So, savvy real estate investors often pride themselves in combining these tax strategies to drastically reduce or even eliminate taxes. This can be a very powerful strategy.

Don’t let the tail wag the dog

Perhaps an even more powerful strategy is to use a Self Directed 401(k). I think where using retirement accounts can add an advantage is by not requiring you to 1031, refi, or follow any restrictive plan in order to defer or eliminate taxes.

Let’s imagine I buy an investment property in my Self Directed 401(k), and you buy a similar property outside of your 401(k). We both want to eliminate or defer taxes. I have more options on how I can proceed with my investment than you do.

1. When I sell my property, I don’t have to buy another one within a few months.
2. I don’t have to continue buying more expensive properties; i.e. “trading up“.
3. I don’t have to use a certain amount of leverage to ensure I have enough interest expenses to sufficiently reduce my taxable income.
4. I don’t have to borrow my gain through a refinance and bear the interest expense. I can just sell.
5. I can focus on maximizing cash flow instead of trying to hit a sweet spot of only getting enough cash flow that can be hidden by depreciation deductions.
6. I can invest in real estate options, mortgage notes, revenue participation contracts, and virtually anything else with my proceeds… including assets in a foreign country.

Repeat this situation over and over, and I believe my additional options will sometimes result in better bottom line investment performance. I want maximization of investment performance as my unconditional primary focus, and that is only possible when I can buy what I want when I want.

Simple Advice: Buy & Sell at Different Times

When I had my mortgage company, I asked one of my wealthiest clients why he didn’t use 1031 exchanges. He explained to me, “Jeff, I’m not a genius. I don’t know everything about the real estate market and what it’s going to do. So I have to keep things simple: I buy when property is cheap, and I sell when property is expensive. Normally these two events are further apart than 180 days, so I don’t use the 1031.” He was basically playing on market cycles. Things go up and come down. He buys when they are down, and sells when they are up. I like to take his philosophy a step further: to fully make use of market cycles you must be prepared to invest in real estate in different locations, and in different ways… (i.e. real estate options, debt instruments secured by real estate, different purchase prices, etc.)

In another item of notability, the inflationary situation is creating an encouraging opportunity for investment into any asset not exposed to US Dollars. You can’t use 1031 to defer the gains of a US property into a foreign property.

Imagine how your next real estate investment will go if you knew you could buy and sell when and where you want and still defer the taxes on income and gains.

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If you talk to the average CPA, he’ll tell you that UBIT is the boogeyman and is to be avoided… always. Discussing this topic with an above average CPA (such as Eric Wikstrom of Integrated Wealth Strategies) yields different advice.

The Two Types of UBIT

1. Triggered from a trade or business – if a tax exempt entity (such as an IRA or 401k) owns a trade or business, the income of that business is taxed at trust rates (i.e. very high tax rates). Both IRA & Solo 401k accounts are subject to this type of UBIT.
2. Triggered from ownership of leveraged real estate – if a tax exempt entity (including IRA) owns real estate leveraged with a mortgage loan, the portion of that income attributable to the mortgage loan is taxed at trust rates. This type of UBIT is specifically referred to as UDFI – Unrelated Debt Financed Income. Solo 401k accounts & other qualified plans are exempt from UDFI.

Trust tax rates are very high, so it might make sense to avoid Type 1 UBIT at all costs. On the other hand, a close examination of UDFI tends to revoke its “boogeyman” status.

The reason UDFI isn’t a detrimental cost is that non-recourse mortgage loans (the only type an IRA/401k can legally obtain) are typically only offered at a 65% loan-to-value maximum. So this means that the UDFI tax is only payable on up to 65% of the property’s net income. (That’s right – net income. You do get to deduct depreciation and other expenses before paying UDFI tax).

Let’s examine a simple comparison of the taxes payable on net real estate income with 50% leverage:

Example A

Example B

The gap between the dollar amount of taxes paid widens as the income increases:

Let’s go back and look at Example B. Take the difference in taxes and examine the long term effects of 25 years of investing and compounding returns. These charts assume a 15% annualized ROI:

Example B1

This uses an effective tax rate of 16.23% for UDFI

Example B2

This uses an individual tax rate of 28%

The result? The IRA has a balance of $631,385.87 more than the individual does.

Conclusion

It might make sense to avoid Type 1 UBIT, while Type 2 UBIT (UDFI tax) results in less taxation than the alternative of investing with individual funds. For those eligible for the Solo 401k, Type 2 UBIT (UDFI tax) generally does not apply.

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